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Key14 You got the basics, so how are financial data used to compare one firm with another?

Suppose you are considering an investment in Compaq Computer Corporation. Competitors in the computer industry include Dell, Gateway, and Apple. You may decide to ignore IBM and Hewlett-Packard, which also make personal computers, because they are in too many other businesses as well. They are not “pure plays.”

After obtaining financial statements (sees Key 25) from the different firms, the next step is to analyze them to learn about the operations and performance. Cross-sectional analysis is the basic approach used to assess a company in comparison with its competitors.

First, identify the important drivers of stock-price appreciation in the industry. Sales growth---the percentage change in sales from one period to another---is probably the most important. If the financial reports break down revenue by segments like hardware, software, and services, you can compare the relative proportions among the competitors. Or you can use the footnotes to evaluate which firms will reap greater benefits from foreign investments; if you suspect their overseas markets are growing faster than the domestic market (sees Keys 23 and 24).

Profitability is also an important factor. To evaluate it, prepare common-size statements by dividing each income statement line by revenue. Each item is thus expressed as a percentage of Revenue. Common-size statements permit comparisons between different-sized firms. Earnings as a percentage of sales are a common profitability measure.

Other income statement data are critical. The Gross Margin ratio (Revenue less Cost of Goods Sold, divided by Revenue), and selling, General and Administrative Expenses (as a percentage of revenue) provide further information as to why profitability differs among companies. Your review could prompt further investigation.

Suppose you learn from your examination that Dell’s business model has a lower cost structure than its rivals do? If you estimate the proportion of costs that are fixed and variable you’ll have insight into how earnings will change if a firm experiences a jump in its revenue.

The DuPont formula is an oft-used tool for analysis. Its virtue is linking profitability from the income statement to the investment base on the balance sheet. The formula is:

(Earnings/Sales) X (Sale/Average total assets) = (Earnings/Average total assets)

Profitability (Earnings/Sales) is multiplied by Turnover (Sales/Assets). The result is a measure of how much profit is earned on the asset base. One company may generate more revenue per dollar of investment. This could occur because of grater manufacturing productivity, extensive out-sourcing, leased rather than purchased equipment, or tighter control of inventory. If two firms’ profitability ratios are the same, than the company with higher turnover will have a larger return on its asset base. The DuPont approach captures these effects.

If a company is able to earn a higher return on assets than its borrowing cost (i.e., its after-tax cost of debt), its stockholders will enjoy this extra margin. The differential return increases return on equity (net income less preferred dividends, divided by average stockholders’ equity).

This is the result of leverage, the strategy of borrowing funds at x%, and employing them for the benefit of stockholders so they earn (x+y) %. Leverage can be measured several ways. Perhaps the most common approach is by dividing average total assets (total assets at year’s beginning and end, divided by two) by average common stockholders’ equity. A second measure, the debt-equity ratio divides long term debt by stockholder’s equity. A third measure models leverage as long-term debt divided by total capitalization (long term debt plus equity).

Industries with relatively stable revenues and expenses are able to carry higher levels of debt. For example, financial service companies typically are highly leveraged. Because profit margins are marrow in this industry, the use of leverage is crucial to increasing stockholders’ return. Managers use the liquidity and relative stability of cash flows from financial services to enable their greater use of debt.

You’ve just been introduced to cross-sectional analysis, profitability measures, and leverage. In Key 15, we’ll discuss some additional techniques for analyzing financial statements.